Accounting for managerial decisions 1

4th sem M.Com

MARGINAL COSTING

Applications of Marginal Costing

Marginal costing is the most powerful and popular technique in aid of managerial
decision making. It reveals the cost, volume profit relationship in all its ramifications
which is useful in profit planning, selling price determination, selection of optimum
volume of production, etc.

Marginal costing is taking a significant place in the total cost of Management

Accountant. It is widely used for planning and decision making.

There are many managerial problems, and marginal costing will be helpful to solve
those problems. The main managerial problems are indicated below which may help
in taking business decisions.

Managerial Problems:
Various important managerial problems are as under:
(The applications of marginal costing)
1. Optimum Sales Mix

2. Market Expansion

3. Make or Buy Decision

4. Product Mix

5. Sales Mix

6. Increase in Level of Activity

7. Dropping a Product

8. Suspension of Activities

9. Sales Channel

10. Sales Promotion Scheme

11. Profit Target

12. Best Level of Activity

13. Introducing New Line of Product

Urmila Naveen MBA, Mcom, PGDBA

Assistant Professor, VVPGC, Tumkur
Accounting for managerial decisions 2
4th sem M.Com

14. Discontinue of a Product

15. Price Change and a Few Others.

1. Optimum Sales Mix:

When a company is engaged in a number of products, there, may arise a problem of
selecting most optimum product mix which would maximise the profit of the concern.
Under such situation, profitability will improve by economising the scare resource
known as key factor.
The product giving highest contribution per unit of key factor should be considered and
then all products are put in ranks in order of priority. Selection of products will offer
optimum product mix or which the profit will be maximum.

2. Market Expansion:
Sales volume can be increased by taking new territories or by extending its own
marketing organisation. It will require an extra expenditure. Marginal costing will be
helpful in providing adequate and relevant data for taking a decision in this regard.

3. Make or Buy Decision:

The nature of decision regarding make or buy may be of the following types:

Every businessmen has to take a decision whether to manufacture the component in

the factory or to buy it from the market. In such cases a comparison of marginal cost
with that of buying price is to be made. Here only marginal cost is the relevant factor
which is to be considered.
If the marginal cost is less than buying price, additional requirement of component is
to be made by making rather than buying it from the markets. Similarly, if buying price
is less than the marginal cost, it will be advantageous to purchase it from the market.
If the market price is less than the production cost, then the component should be
purchased from the market.
A decision has to be taken whether a component should be purchased from the market
or it should be produced in the factory.
If additional costs are less than the buying price, the component should be
manufactured and vice versa.

4. Product Mix:
When any company produces a number of products, then a problem may arise of
selecting most optimum product mix which would provide the maximum profits.

5. Sales Mix:
Problem of sales mix arises when a business concern is producing more than one
product. Each product might be yielding different amount of contributions. The
management goal is only to get maximum profit. The ratio of quantities to be sold

Urmila Naveen MBA, Mcom, PGDBA

Assistant Professor, VVPGC, Tumkur
Accounting for managerial decisions 3
4th sem M.Com

various products in such a manner as to earn maximum profit. It is known as optimum

sales mix.
It is ascertained with the help of contribution per unit. The product which gives the
highest contribution is given the highest priority. Out of the various sales mix, that sales
mix is selected which provides the maximum profits.

6. Increase in Level of Activity:

If any concern is not making adequate profit, the level of activity may be increased by
reducing the price and removing the shortage of materials; shortage of skilled labour
or market situations etc. In all these positions, marginal costing is taken into
consideration.

7. Dropping a Product:
The businessmen want to earn maximum profits out of his limited resources. It requires
to fix priorities for various products. The management would like to drop the production
of unprofitable product. It will based on the comparative study of contributions made
for each product.

8. Suspension of Activities:
Sometimes due to competition or other reasons, the business concern may not be in
a position to carry out its trading activities. Thus trading activities are suspended.
These suspension may be of two types as under:
(i) Temporary Suspension – During off season, trading activity is closed temporarily
for short period. It is known as temporary suspension.
(ii) Permanent – But when on account of depression, in case of continuous loss, the
trading activity can be suspended permanently.

9. Sales Channel:
Sometimes the trader is faced with the problem of selecting the most profitable
channel of distribution. With the help of marginal costing technique, the
contribution may be ascertained and correct decision may be taken in time.
Under it, that channel of distribution should be selected which may provide
maximum contribution. Selling and distribution expenses should be considered
as a part of marginal cost for calculating contribution.

10. Sales Promotion Scheme:

The management has to evaluate the profitability of various sales schemes which may
cover trade discount free gifts, extra commission and price reduction etc. In all these
cases, marginal costing will help in assessing the profit through contribution analysis.
If goes to increase the total contribution, the profit in that case will be maximum.

11. Profit Target:

Marginal costing is used by management in profit planning.

Urmila Naveen MBA, Mcom, PGDBA

Assistant Professor, VVPGC, Tumkur
Accounting for managerial decisions 4
4th sem M.Com

A profit target is fixed and management tries to achieve it by making changes in

the factors given below:
(i) Quantity sold
(ii) Variable cost per unit
(iii) Sales mix
(iv) Selling price
(v) Total fixed costs.
With the help of marginal costing, the management can easily evaluate the desired
profit and can examine the improvement in profit position.

12. Best Level of Activity:

Level of activity of business is expanded or contracted according to the market
conditions. Management selects that level of activity which would provide maximum
profits. The level of activity is optimum, where marginal cost equals to marginal
revenue. The level of activity can be expanded up to the level where sales exceeds
marginal costs.

13. Introducing New Line of Product:

Whenever a new product is to be added the problem may arise that whether a new
product is to be added or the new shape or new model is to be added. If there are
many model then the management has to decide that which model should be selected.
In such situation, the marginal cost of new product of all models should be considered.
Some additional investment may be required which may increase the fixed cost.

14. Discontinue of a Product:

Marginal cost will help the management in taking a decision regarding continuance of
a product from the market. Besides marginal cost, the other expenses are selling
expenses, salesman commission, distribution expenses, advertisement etc. The
selling price may differ from market to market. Discontinuance of a market will
eliminate variable expenses but selling and distribution expenses are to be compared
with the fixed expenses. Till any market yields contribution, it should not be
discontinued.

15. Price Change:

It is contended that price in short term should cover total cost and profit. But in a
competitive market, price is determined by the market forces. In this connection,
marginal costing is helpful in price determination in short run.
Price in long run should be as much as to cover total cost and normal profit. But in the
competitive world, minimum price has to be determined. If any item of cost seems to
be irrelevant, it should be ignored and should not be taken into account in determining
the price.

Urmila Naveen MBA, Mcom, PGDBA

Assistant Professor, VVPGC, Tumkur
Accounting for managerial decisions 5
4th sem M.Com

Cost-Volume-Profit (CVP) Analysis

The cost-volume-profit analysis, also commonly known as breakeven analysis, looks

to determine the breakeven point for different sales volumes and cost structures,
which can be useful for managers making short-term business decisions.
CVP analysis makes several assumptions, including that the sales price, fixed and
variable cost per unit are constant. Running a CVP analysis involves using several
equations for price, cost, and other variables, then plotting them out on an economic
graph.
The CVP formula can be used to calculate the breakeven point. The breakeven point
is the number of units that need to be sold, or the amount of sales revenue that has to
be generated, in order to cover the costs required to make the product. The CVP
breakeven sales volume formula is:

Breakeven Sales Volume= FC ÷ CM

where: FC = Fixed costs

CM = Contribution margin
Contribution Margin = Sales−Variable Costs

Break even analysis

The study of cost volume profit relationship is often referred to as Break even analysis.

The term Break even analysis is interpreted in narrow as well as broad sense.

In its narrow sense In its broad sense

It is concerned with finding out the break It is concerned with the determination of
even point. probable profit at any level of production.

Break even point

It is the point at which total cost is equal to total sales i.e., point of no profit & no
loss.
Assumptions of Break even Analysis

1. All cost can be separated into fixed and variable components

2. Fixed costs will remain constant at all volumes of output
3. Variable costs will fluctuate in direct proportion to volume of output
4. Selling price will remain constant

Urmila Naveen MBA, Mcom, PGDBA

Assistant Professor, VVPGC, Tumkur
Accounting for managerial decisions 6
4th sem M.Com

5. There is only one product or in case of multiple products the sales mix will
remain constant
6. Production and sales will be synchronised
7. productivity per worker will remain unchanged
8. There will be no change in the general price level
Uses of Break even Analysis

1. Determination of the selling price which will give the desired profits
2. Forecasting costs and profit as a result of changing volume
3. Suggestions for shift in sales mix
4. Inter-firm comparison of profitability
5. Determines costs & revenue at various levels of output
6. Impact of increase & decrease in fixed or variable costs on profits
7. Fixation of sales volume level to cover a given return on capital employed

Limitations of Break even analysis

• Doesn’t predict demand – Although a break-even analysis can tell you when
you’ll break even, it doesn’t give you any insight into how likely that is to happen.
Plus, demand isn’t stable, so even if you think there’s a gap in the market, your
break-even point could end up being a lot more ambitious than you initially
thought.
• Depends on reliable data – In short, the accuracy of your break-even analysis
is dependent on the accuracy of your data. If your calculations are wrong or
you’re dealing with fluctuating costs, break-even analysis may not be the most
useful tool in your arsenal.
• Too simple – Break-even analysis is best for companies with one price-point.
If you have multiple products with multiple prices, then break-even analysis may
be too simple for your needs. In addition, it’s worth remembering that costs can
change, so your break-even point may need to be evaluated and adjusted at a
later time.
• Ignores competition – Another limitation of a break-even analysis concerns
the fact that competitors aren’t factored into the equation. New entrants to the
market could affect demand for your products or cause you to change your
prices, which is likely to affect your break-even point.

Urmila Naveen MBA, Mcom, PGDBA

Assistant Professor, VVPGC, Tumkur